Black Scholes Model

28-11-2020
Black-Scholes-Merton Model
Sankarshan Basu
Professor of Finance
Indian Institute of Management Bangalore
Lognormal Property of Stock Price

• It follows from this assumption that
 2  
ln ST  ln S0      T,  T 
 2  
or
  2  
ln ST   ln S0     T,  T 
  2  
• Since the logarithm of ST is normal, ST is

lognormally distributed.
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Lognormal Property of Stock Price–

Example
• Consider a stock with an initial price of
$40, an expected return of 16% per
annum, and a volatility of 20% per annum.
The probability distribution of the stock
price, ST, in six months' time is given by
  0.2 2  
ln ST ~  ln 40   0.16   * 0.5, 0.2 0.5 
  2  
ln ST ~ 3.759,0.141
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Lognormal Property of Stock Price–

Example
• There is a 95% probability that a normally
distributed variable has a value within 1.96
standard deviations of its mean.
• Hence, with 95% confidence,
3.759 - 1.96*0.141 < In ST< 3.759 + 1.96*0.141
• This can be written
e3.759-1.96*0.141 < ST < e 3.759+1.96*0.141
or, 32.55 < ST < 56.56
• Thus, there is a 95% probability that the stock
price in six months will lie between 32.55 and
56.56.
The Concepts underlying Black-Scholes-

Merton Differential Equation
• The option price and the stock price depend
on the same underlying source of uncertainty.
• We can form a portfolio consisting of the
stock and the option which eliminates this
source of uncertainty.
• The portfolio is instantaneously riskless and
must instantaneously earn the risk-free rate.
• This leads to the Black-Scholes-Merton
differential equation.
Assumptions
1. The stock price follows the Ito process (Geometric
Brownian Motion) with µ and σ constant. This implies
ds = µS dt + σS dz
2. The short selling of securities with full use of proceeds is
permitted.
3. There are no transactions costs or taxes. All securities are
perfectly divisible.
4. There are no dividends during the life of the derivative.
5. There are no riskless arbitrage opportunities.
6. Security trading is continuous.
7. The risk-free rate of interest, r, is constant and the same
for all maturities.
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Derivation of the Black-Scholes-

Merton Differential Equation
S  S t  S z
 ƒ ƒ 2 ƒ  ƒ
 ƒ   S   ½ 2  2 S 2 t  S z
 S t S  S
We set up a portfolio consisting of
 1 : derivative
ƒ
+ : shares
S
Derivation of the Black-Scholes-Merton

Differential Equation– contd.
The value of the portfolio  is given by
ƒ
  ƒ  S
S
The change in its value in time t is given by
ƒ
    ƒ  S
S
 f 1  2 f 2 2 
    S t
 t 2 S 2
 
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The Derivation of the Black-Scholes-

Merton Differential Equation – contd.
The return on the portfolio must be the risk - free
rate. Hence
  r t
We substitute for  ƒ and S in these equations
to get the Black - Scholes - Metron differential
equation :
ƒ ƒ  2ƒ
 rS  ½  2S 2 rƒ
t S  S2
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The Differential Equation

• Any security whose price is dependent on
the stock price satisfies the differential
equation.
• The value of a forward contract given by the
following equation satisfies the Black-
Scholes differential equation.
ƒ = S – K e–r (T – t )
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Risk-Neutral Valuation
• The variable  does not appear in the Black-
Scholes differential equation.
• The equation is independent of all variables
affected by risk preference.
• The solution to the differential equation
therefore is in the risk-free world.
• This leads to the principle of risk-neutral
valuation.
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Applying Risk-Neutral Valuation

1. Assume that the expected return from
the stock price is the risk-free rate.
2. Calculate the expected payoff from the
option.
3. Discount at the risk-free rate to
calculate the price of the option.
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The Black-Scholes-Merton
Option Pricing Formulas
c  S 0 N (d1 )  K e  rT N (d 2 )
p  K e  rT N (d 2 )  S 0 N (d1 )
ln( S 0 / K )  (r   2 / 2)T
where d1 
 T
ln( S 0 / K )  (r   2 / 2)T
d2   d1   T
 T
Where c = Max(E(ST – K, 0)) and p = Max(E(K – ST, 0))
and ds = µS dt + σS dz
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Impact of change in parameters on

option prices
• c = SN(d1) – X e-rt N(d2)
• p = X e-rt N(-d2) – SN(-d1)
• d1 =(1/T)*ln(S/X) + (r T/) + (T/2)
• d2 =(1/T)*ln(S/X) + (r T/) - (T/2)
• S increases, call increases, put goes to 0
• X increases, put increases, call goes to 0
• r increases, call goes S, put goes to 0
•  increases, call increases, put increases
• T increases, call increases to S, put goes to 0
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Implied Volatility
• The implied volatility of an option is the
volatility for which the Black-Scholes price
equals the market price.
• Traders and brokers often quote implied
volatilities rather than dollar prices.
• Pl see implied volatility figures of Indian stocks
and stock indices on NSE (assuming 10% risk-
free rate)
https://www1.nseindia.com/live_market/dynaC
ontent/live_watch/option_chain/optionKeys.jsp
?symbol=NIFTY&instrument=-&date=-
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Estimating Volatility from Historical

Data
• Take observations S0, S1, . . . , Sn at intervals of t
years for n+1 no. of observations.
• Calculate the continuously compounded return in
each interval as:
 S 
ui  ln i 
 S i 1 
• Calculate the standard deviation, s , of the ui´s
s
• The historical volatility estimate is  ˆ 
t
• The standard error of this estimate is approximately
ˆ

2n
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Nature of Volatility
• Volatility is usually much greater when the
market is open (i.e. the asset is trading)
than when it is closed.
• For this reason time is usually measured
in “trading days” not calendar days when
options are valued.
• Volatility per annum
= Volatility per trading day*√(Number of
trading days per annum)
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Dividends – European Options

• European options on dividend-paying
stocks are valued by substituting the stock
price less the present value of dividends
into Black-Scholes-Merton pricing
formula.
• The “dividend” should be the expected
reduction in the stock price expected.
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Pricing of European Stock Option

with Dividend – Example
• Consider a European call option on a stock when
there are ex-dividend dates in two months and
five months. The dividend on each ex-dividend
date is expected to be $0.50.
The current share price is $40, the exercise price
is $40, the stock price volatility is 30% per
annum, the risk-free rate of interest is 9% per
annum, and the time to maturity is six months.
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with Dividend – Example
• The present value of the dividends is
= 0.5e-0.1667*0.09+ 0.5e-0.4167*0.09 = 0.9741
• The option price can therefore be calculated

from the Black-Scholes-Merton formula with
So = 40 – 0.9741 = 39.0259,
K = 40, r = 0.09,
σ = 0.3, and T = 0.5.
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with Dividend – Example– contd.
• We have
• The call price is:
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Dividend – American Calls

• An American call on a non-dividend-paying
stock should never be exercised early.
• An American call on a dividend-paying stock

should only ever be exercised immediately
prior to an ex-dividend date.
• Suppose dividend dates are at times t1, t2, …tn.
Early exercise is sometimes optimal at time ti if
the dividend at that time ≥ K [1  e  r (ti1 ti ) ]
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Black’s Approximation for Dealing with

Dividends in American Call Options
Set the American price equal to the maximum
of two European prices:
1. The 1st European price is for an option
maturing at the same time as the American
option
2. The 2nd European price is for an option
maturing just before the final ex-dividend date
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Problem No. 1
• What is the price of a European put option
on a non-dividend-paying stock when the
stock price is $69, the strike price is $70,
the risk-free interest rate is 5% per annum,
the volatility is 35% per annum, and the
time to maturity is six months?
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Problem No. 1 (Ans.)

• The price of this European put option
= 6.40
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Problem No. 1 (Explanation)

In this case,
S0  69, K  70, r  0.05,   0.35 and T  0.5
ln(69 / 70)  (0.05  0.352 / 2)  0.5
d1   0.1666
0.35 0.5
d 2  d1  0.35 0.5  0.0809
The price of the European put is
70e 0.05*0.5 N (0.0809)  69 N (0.1666)
 70e 0.05*0.5 * 0.5323  69 * 0.4338
 6.40
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Problem No. 2
• Consider an American call option on a stock. The
stock price is $70, the time to maturity is eight
months, the risk-free rate of interest is 10% per
annum, the exercise price is $65, and the
volatility is 32%.
A dividend of $1 is expected after three months
and again after six months.
Show that it can never be optimal to exercise the
option on either of the two dividend dates.
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Problem No. 2 (Ans.)

Using the notations,
D 1  D 2  1, T  t 2  2 m  0.1667, t 2  t 1  3 m  0.25.
K(1  e  r(T  t 2 ) )  65(1  e  0.1* 0.1667 )  1.07
and K(1  e  r(t 2  t 1 ) )  65(1  e  0.1* 0.25 )  1.60
Since D1  K(1  e  r(T  t 2 ) )
and D 2  K(1  e  r(t 2  t 1 ) )
It is never optimal to exercise the call option early.
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28-11-2020

Lognormal Property of Stock Price

• Since the logarithm of ST is normal, ST is

Lognormal Property of Stock Price–

Lognormal Property of Stock Price–

The Concepts underlying Black-Scholes-

Derivation of the Black-Scholes-

Derivation of the Black-Scholes-Merton

The Derivation of the Black-Scholes-

The Differential Equation

Applying Risk-Neutral Valuation

Impact of change in parameters on

Estimating Volatility from Historical

Dividends – European Options

Pricing of European Stock Option

Pricing of European Stock Option

• The option price can therefore be calculated

Pricing of European Stock Option

• The call price is:

Dividend – American Calls

• An American call on a dividend-paying stock

Black’s Approximation for Dealing with

Problem No. 1 (Ans.)

Problem No. 1 (Explanation)

Problem No. 2 (Ans.)

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